Great Investment Articles

This article, from February, gives a great overview of the commodities bull market we expect and why we believe select commodity stocks represent the best investments for the long term.

Scott Wright February 3, 2006

The turn of the century has brought upon a change of guard for the financial markets. The general stock markets peaked and a new secular commodities bull was born. Even though many have had to endure the pain of a bursting stock-market bubble, the global economy has been thriving since the turn of the millennium and I suspect those in the future will look back on the 21st century and tag it as the Consumption Age.

Globally this consumption is not necessarily that of excess or overindulgence. Rather it may be considered more or less a movement of economic progressivism. Lending part to this trend is the fact that our global population is growing at a blistering pace and will continue to do so for years to come. Many people overlooked the incredible milestone that was attained in 1999. Our enduring planet lofted above the six billion mark in total population.

To put this growing and changing world into perspective, it was only about 200 years ago that the global population passed the one billion mark. According to the U.S. Census Bureau it only took another 118 years for the global population to double, reaching two billion in 1922. It then took 37 years to reach three billion, 15 years to reach four billion, 13 years to reach five billion and only 12 years to reach six billion.

Today we are already past the half-way mark to the next billion. Now with 6.5 billion potential consumers living in an era in which considerable industrial and technological advances are demanding more resources than ever, it’s no wonder global demand for commodities has soared. In this high-tech world we live in, commodities are zealously sought after in order to maintain, support and develop this growing population. Because of this, commodities of all types are soaring in value as their availability and economics are continually being challenged. Simply put, supply has not been able to keep up with demand.

This massively increasing population has contributed to an increase in consumption in virtually all goods and services, and in turn has contributed to the robust economies we are seeing today that are seemingly necessary in order to maintain status quo. Almost not surprising, GDP in the U.S. has increased ten-fold since 1972, China has seen a ten-fold since 1978 and the U.K. has seen its ten-fold since 1976. The macroeconomics we see here tell an incredible story in which commodities have and will play a large part now and in the future.

It is important for everyone to understand why we are in the midst of a commodities craze from a socioeconomic perspective, if for no other reason than to understand how it may affect their everyday lives. It is especially important to understand this if you are an investor. Investors and speculators who have taken part in the commodities bull thus far have scored incredible gains if they have played the upside of this secular trend.

It’s not too late though to continue to profit from this commodities bull. We are still likely in the first half of a long-term bull market. To this day commodities of all sorts are still in the midst of major economic imbalances. Global demand for both soft and hard commodities is on the rise and supply is struggling to keep up. It is the prudent investor or speculator who is able to recognize this pattern before it corrects itself and is able to leverage his capital to take advantage of the upside.

Our task now is to determine which commodities to focus on from an investment perspective. Now depending on whom you ask and where you look, the definitions for soft and hard commodities tend to range across the board. For our purposes we will consider any commodity that can be grown or raised a soft commodity, and any commodity that you have to mine or drill for a hard commodity.

Soft commodities tend to have a renewing characteristic. Crops can be re-grown, and typically in the same spot as the previous crop. And meat commodities are the result of animal breeding that has remarkably accurate forecasting. Softs are integral in this bull market, but are not the major player.

Commodities such as coffee, cotton, cocoa, orange juice and hogs are examples of soft commodities and are all non-finite in nature. As long as a global ice age doesn’t miraculously strike the earth, crops will always be grown. And I surely doubt that cows, pigs and chickens will ever become extinct.

Now there are external factors that can influence the pricing of these soft commodities and they are certainly not exempt from supply and demand pressures. Weather, disease, geopolitical unrest and labor are examples of some of these factors. But when an economic imbalance presents itself, the fact that these commodities are renewable typically avoids a pushing of the panic button.

Even so, soft commodities continue to play a large role in the overall futures markets and are not exempt from the volatility most people associate with commodities. Farmers need to lock in prices and speculators play the game to try and capture profits.

In come hard commodities. Hards consist mainly of energy and metals and require extensive capital expenditures in order to retrieve these commodities from the earth. These commodities are finite in nature and have limited resources. Hards have been on a tear the last four years, have captured mainstream media attention and are the major player in this secular commodities bull market.

Precious metals, crude oil and natural gas are not the only commodities that have taken part in this bull. These commodities do command the lion’s share of attention but let’s not overlook those others that play an integral part in the global economy. Below are many of the popular hard commodities and their bull-to-date highs since the beginning of 2001.

- Aluminum +94%
- Gold +124%
- Silver +142%
- Platinum +159%
- Zinc +220%
- Lead +252%
- Copper +280%
- Crude Oil +300%
- Nickel +302%
- Butane +330%
- Propane +346%
- Heating Oil +360%
- Gasoline +578% (+333% not including Katrina/Rita 3-day spike)
- Natural Gas +807% (+429% not including Katrina/Rita spike)

As you can see, these hards have had quite a run thus far and we’ll touch on them in more detail later. But in addition to these above, there are many other soft and hard commodities that trade in the futures markets. On top of analyzing each individually, it is equally important to get an overall perspective on the look and feel of this bull market in order to grasp the long-term trend of this commodities bull.

A good way to package all these commodities together and obtain this high-level look is to turn to the flagship CRB Commodities Index. The CRB Index has long been the benchmark that many investors use in order to track the overall progress of commodities.

Our first chart below provides an excellent representation of the development and progression of this commodities bull market. The 2001 low we see in this chart is the second bottom to a massive double-bottom in which the first in 1999 was within a point of what we see here. This bottom represents the lowest point the CRB has been since 1975.



As you can imagine, barring the occasional bear-market rally, commodities have been out of favor for quite some time. Today’s commodities bull is finally reflecting the importance of commodities and the realization that in this growing global economy the resources that support it are not to be taken for granted.

The CRB Index beautifully reflects this bullish trend. As you can see on this chart, the last four years display a textbook bullish footprint. The CRB Index has stayed within a relatively tight trend channel and has continued to produce higher lows and higher highs. In fact, just recently it surpassed its all-time high! In 1980 the CRB Index closed at its previous all-time high, but today’s commodities bull shattered it in recent weeks and has not looked back. Since its bottom in 2001, the CRB Index has risen 91%!

Now that we have our baseline for the look and feel of this commodities bull, let’s revert back to our soft versus hard commodity discussion. Currently the CRB Index is comprised of 19 commodity components. Today’s mix weights 59% as what we are calling hard commodities with soft commodities capturing the remaining 41%.

Interestingly, 9 of 19 components in the CRB Index are hard commodities, of which each is included in the list of 14 above. As mentioned previously, each of these gains are spectacular. While many hard commodities today are still hovering around their bull-to-date highs, most of the soft commodities that have actually produced gains are quite a bit off of theirs.

The 10 components that rank as soft commodities in the CRB Index have not had as impressive of a run thus far as hards. Corn and hogs are trading at the same prices today as they were in 2001. Wheat, soy beans and orange juice are up less than 50% from their 2001 lows. Cattle and cocoa are up a meager 62% and 87% respectively from their 2001 lows. And only coffee, cotton and sugar can boast gains in excess of 100% since the inception of this bull market.

Sugar is the truly interesting story among the softs. It has performed very well in this bull market, but for reasons that would exhibit the characteristics of a hard commodity. It recently hit a 25-year high not because more people are putting sugar in their coffee, but rather due to the huge increase in ethanol demand.

Sugar happens to be a common compound in ethanol production with well over 50% of the global ethanol supply coming from it. Ethanol consumption has significantly increased over the years and its demand is expected to continue to rise sharply in the years to come. As more and more countries are implementing ethanol as an alternate energy source we are now faced with a supply-deficit in sugar.

In fact, ethanol has been in such demand that both the New York Board of Trade (NYBOT) and the Chicago Board of Trade (CBOT) recently introduced futures contracts for sugar-derived ethanol. Because of this it is quite possible we may see gains in sugar that exceed the 282% we’ve seen since 2000.

Even with sugar as the stand-out soft commodity, it is evident that hard commodities are the strongest of the group and have been pulling their weight, hoisting the overall index. As with all indexes, the CRB Index went through a revision last July in order to reflect the weightings we see above. Hard commodities now become more of a focus and the results going forward should reflect more on their performance.

But now we look at the CRB Index, or commodities in general, and ask ourselves, why should we buy at all-time highs? But wait, are we truly experiencing all-time highs? Nominally yes, but in real terms, absolutely not! My partner Adam Hamilton penned an essay last year when the CRB Index broke 300 for the first time since 1981 and went into great detail on this topic. One of the charts he developed took a look at the inflation-adjusted CRB Index, and it revealed dramatic results.

I’d like to update this chart and show you why commodities, reflected through the CRB Index, are still relatively cheap in today’s dollars. When analyzing long-term price trends, it is always prudent to compare apples to apples and consider the true value of a dollar. Due to the relentless rolling of presses by the inflation-crazed Federal Reserve, a dollar today has nowhere near the purchasing power it did in 1981. And we need to highly consider this when we discuss the true value of a commodity.



If you only consider the nominal price of the CRB Index, then today’s highs are phenomenal as indicated by the blue nominal CRB line above. But when you factor inflation into the mix, as indicated by the red real CRB line, today’s prices are not as exciting as originally thought and it shows we still have a long way to go before true highs are met.

All we did was simply factor in the conservative CPI data in order to compare the purchasing power of today’s dollar to that of it in the past. The above chart reveals the fascinating reality of the true progress of this commodities bull market. In real terms, the CRB would have to nearly triple from today’s levels in order to approach its all-time high. This is a massive 200% increase over the nominal highs we’ve seen in the past month.

In real terms, today’s commodities prices are actually trading at the same levels they were in the early 1990s. In order to approach its real high in 1980, the CRB Index would have to rally up to over 777. And because of inflation, the 1980 nominal high is in fact not the true high as seen by the pinnacle achieved in 1974. Imagine the CRB Index trading at 1000! Well, this is what it would have to trade at in today’s dollars in order to equal its true all-time high. Commodities are still cheap!

Now that we’ve established the fact that commodities have enormous potential even at the nominal highs we are seeing today, how does an investor jump on board and leverage his capital in order to profit from this? Believe it or not there actually is a reason why I broke down the commodity types between soft and hard. In my humble opinion softs are nowhere near as exciting as hards, but regardless of this opinion, softs are just plain more difficult to invest in.

As an example, let’s say I saw further potential in sugar and wanted to jump on its bandwagon. Only one problem presents itself, I’m the average Joe investor, I invest in stocks, and not only do I not have a futures trading account, but I am not even interested in futures trading, way over my head!

Well, if you look real hard you will find various hedge funds out there that have recognized sugar’s potential and have thrown capital in its direction. But ultimately for the common investor there is really not an easy way to get a piece of the pie. Soft commodities are almost exclusively traded in the futures markets. You would be hard pressed to find a publicly traded company that produces a soft commodity and is exposed to its price fluctuations.

Hard commodities, on the other hand, offer wonderful opportunities for investors to join the party. Because of the massive capital expenditures and operating costs necessary to produce hard commodities, and because funding is always a challenge, most producers and servicers of these sorts are publicly traded in the stock markets.

With this, we need to again keep in mind the underlying reason why the CRB Index was revised to favor hard commodities. Its custodian’s goal is to reflect the commodities that are most important and influential in today’s economy. Energy and metals are such commodities today and are currently faced with serious economic and fundamental challenges.

Demand for these resources has reached unprecedented territory in order to service today’s global economy. And the supply that is being mined and drilled is not only slow to meet this demand, but for many of these commodities the reserves for future supply are quickly dwindling with new discoveries becoming increasingly difficult to find.

The reason you see these immense gains in hard commodities is because of the now and future economic imbalances that present themselves. For many years capital has poured into the general stock markets with focus on tech stocks, and though commodities need significant funding in order to sustain future supply, the funds had just not made it their way. For many years exploration budgets were slashed and new discoveries were few and far between. This brazen ignorance of commodities for so long has finally commanded the world’s attention.

It’s going to take many years for commodities producers to ramp up output in order to meet this increasing demand and even more to renew and build reserves for future sustainability. Because of this prices will most likely continue to rise as much-needed capital is directed towards these commodities producers. At Zeal we have gone into great detail analyzing the core economic fundamentals and imbalances that many hards are faced with, and I encourage you to research and discover the problem the world is grappling with today.

Now as mentioned earlier, the wonderful thing about these hard commodities producers is that most are publicly traded companies. Investors and speculators indeed have the opportunity to leverage their capital at the epicenter of this global commodities shortage.

Some commodities producers are more leveraged than others to their underlying product, but ultimately the stocks of these producers can be looked at as non-expiring call options in their various sectors that should continue to soar as this secular bull market in commodities climbs.

The stocks for many of these companies have produced gains far better than those of their underlying commodities thus far. And as the prices of their products rise as we expect them to, if they are leveraged correctly so will their profits rise. The continued appreciation of their stock price will reflect such.

The bottom line is commodities are still in the early part of a secular bull market. The global economy is starved for commodities and producers are struggling to keep up with demand. It will take many years for today’s economic imbalances to correct themselves and prices should only continue to rise.

The best way for investors and speculators to leverage their capital in order to take advantage of this commodities bull market is to invest in the stocks of the companies that produce these commodities.